Question

What is the FASB guidance on the accounting of premiums and coupons? Discuss with examples.

Answer 1

FASB GUIDANCE :

Introduction A1. This appendix describes in general terms certain provisions of this Statement and provides two examples of their application. The examples are simplified and are not intended to serve as a guide for all of the detailed calculations that may be necessary in applying this Statement.

Change in Prepayment Assumptions Used to Measure the Premium Receivable A2. This Statement states that the period of a financial guarantee insurance contract is the expected period of risk, which is generally the contract period. However, in some instances, the period of risk is significantly shorter than the full contract period due to expected prepayments. The expected period may be used only if a homogenous pool of assets underlying the insured financial obligation is contractually prepayable. In those instances, prepayment assumptions may be used to determine an expected period if prepayments on the insured financial obligation are probable and the timing and amount of prepayments can be reasonably estimated. If an expected period is used, an insurance enterprise should adjust the prepayment assumptions when those assumptions have changed. The adjustment to the unearned premium revenue shall equal the adjustment to the premium receivable with no effect on earnings at the time of the adjustment. The accounting when prepayment assumptions change and the resulting change to the expected period required by paragraph 13 is illustrated below.

Example 1—Change in Prepayment Assumptions A3. The example below assumes that annual premiums are received as payments over the expected period of the financial guarantee insurance contract. The following are the relevant assumptions used in this example:

KEY FACTS :

TOTAL PRINCIPLE OUTSTANDING $7,50,00,000

PREMIUM RATE 100 BASIS POINTS , ANUALLY , RECIEVED AT THE BEGINNING OF THE PERIOD.

CONTACT PERIOD 10 YEARS

INITIAL EXPECTED PERIOD 7 YEARS

DISCOUNT RATE AT INCEPTION 5%

FOR SIMPLICITY , THE CURRENT RISK-FREE DISCOUNT RATE HAS NOT BEEN UPDATED IN THIS EXAMPLE WHEN THE PREPAYMENT ASSUMPTIONS CHANGE AS REQUIRED BY PARAGRAPH 13 OF THIS STATEMENT. IF THE DISCOUNT RATE HAD CHANGED AT THE TIME OF THE CHANGE IN PREPAYMENT ASSUMPTIONS , THAT NEW DISCOUNT RATE WOULD BE USED.

A4. Table 1 illustrates the following amounts, estimated at inception: (a) the expected insured principal amounts outstanding during each period, (b) the expected insured principal payments, (c) the expected premium payments, and (d) the present value of premiums expected. The constant rate is calculated as the ratio of the present value of the premiums expected to be collected and the sum of all insured principal amounts outstanding during each reporting period.

A5. Table 2 illustrates the rollforward of the premium receivable from period to period. The premium receivable will decrease during the year as expected premium payments are received, and it will increase as a result of the accretion of the discount on the premium receivable each period that is recognized in earnings.

A6. Table 3 illustrates that the expected total revenue recognized each period will be the sum of the expected premium revenue recognized each period based on the constant rate of 0.0090729 and the accretion of the discount on the premium receivable each period. (Note: The depiction of “expected premium revenue recognized” and “accretion of discount on premium receivable” in this table is not intended to draw any conclusions about the presentation of these amounts in the statement of income).

A7. Table 4 illustrates the reduction of the unearned premium revenue due to the recognition of premium revenue during each reporting period .