Combination of Contracts
Topic 2 is more critical to non-life insurance business than life insurance, with fronting business being slightly more emphasized. In this perspective, there are three stakeholders: a Policyholder Company (The company that buy insurance policies); a Fronting Company; and a Captive Insurance Company. These three companies can engage in a special form of transaction together that requires special attention and are brought for adjustment under IFRS 17.
This section focuses on addressing the issue of "shell game" transactions where the insurance company acts as a Fronting Company, receiving premiums and then passing them on, resulting in inflated sales figures.
This type of Fronting arrangement involves a Policyholder Company paying premiums to an insurance company acting as a Fronting Company. Subsequently, the Fronting Company passes on these premiums (potentially to another insurance company acting as the reinsurer).
Therefore, if an insurance company can engage in Fronting frequently, it can appear to inflate its sales figures significantly. For example, it might receive premiums amounting to 1,000 million baht but pass on 999 million baht as premiums to another entity.
For example, consider an insurance company operating under Thai law, which practices "Regulated Fronting." They receive insurance premiums totaling 100 million baht and subsequently transfer 99 million baht to another country in the form of Captive Insurance Premiums. Under the IFRS 17 accounting standard, only 1 million baht can be recorded as revenue for the company acting as the Fronting entity in Thailand. This restriction aims to prevent sales manipulation (known in financial terms as "Window Dressing").
This article emphasizes preventing Window Dressing, where sales figures appear artificially inflated beyond actual performance. This technique has been used by some international insurance companies to manipulate their insurance volume.
Specifically addressed by this second section, if the Policyholder company is the same counterparty or affiliated with the Captive insurance company, the standards mandate their Combination of insurance contracts. This means that revenue recognition must strictly adhere to net amounts only, prohibiting any form of sales puffery.
Furthermore, another instance where Combination is required is when the Policyholder company allows the Captive insurance company to undertake and act as underwriting company. This undertaking means the Policyholder company agrees that the Fronting company can pass through all liabilities and responsibilities to the Captive insurance company, effectively treating them as a single entity. In such cases as well, Combination is mandated under the standard.
In practice, only the underwriters at the Fronting company typically know whether transactions like these should be Combination or not. It can be difficult for others to discern, and if the Fronting company subtly manipulates endorsements or engages in deceptive practices, it might go undetected during audits. Hence, this section is highlighted as the second part to ensure that regulators and auditors can prevent sales manipulation.
In an exception, purchasing Excess of Loss (XOL) coverage does not necessarily require Combination because it is considered a routine operation under existing practices. Therefore, sales figures can be recorded without netting, reflecting actual volumes accurately.
In cases where the Policyholder company is the same as the Fronting company and the Captive insurance company, it often occurs that the Captive insurance company refunds money back to the Policyholder, resembling an experience refund. However, in practice, such refunds typically do not happen (due to tax reasons involving double taxation), unless the Policyholder company incurs losses and requires capital injection from the Captive insurance company.
Another scenario involving Combination is when an insurance company undertakes a large project with sum insured exceeding its capacity (sometimes over tens of millions of baht). Unable to bear the risk alone, the company seeks co-insurance partners. This approach differs from traditional insurance in that the Policyholder company knows which companies are sharing the insurance coverage (unlike reinsurance, where the Policyholder company does not know who the insurer is). Consequently, the Policyholder company accounts for only the portion of the risk it assumes, rather than recording the entire sum of ten million (in the event that insurance company and the Policy company are the same party).
Written by Master Tommy (Pichet)
FSA, FIA, FRM, FSAT, MBA, MScFE (Hons), B.Eng (Hons)
All rights reserved for the content of this article. Do not use it for any commercial gain. In addition to receiving permission from ABS company only.
Comentários